Steadier Ways to Play the China Rally

NEW YORK (TheStreet) -- China funds have been rallying. During the past three months, the average China fund returned 12.1%, according to Morningstar. Investors have taken notice of the strengthening environment, putting $2 billion into iShares FTSE China 25 Index ETF FXI this year. Positive economic news has been spurring the market gains, says Morningstar analyst Patricia Oey. Retail sales in China have been climbing, growing at an annual rate of 14.5% in October. After slowing for months, industrial production growth has stabilized at a healthy annual rate of 9%. Economists say the improving picture may be connected to a temporary increase in infrastructure spending this year. The government mandated the stimulus to strengthen the economy at a time when a new leadership team is about to take office.

Still, the data have helped to mute fears that the country could sink badly and face what economists call a "hard landing." Bulls say the China rally can continue. After struggling in recent years, Chinese stocks sell at modest prices. The FTSE China 25 Index only has a price-earnings ratio of 8.5, compared to a figure of 14 for the S&P 500. While the iShares fund is the largest China ETF, it presents considerable risks. The problem is the ETF has 58% of its assets in financials. Big holdings include China Construction Bank and Industrial and Commercial Bank of China. If China's banks ever sink, the fund would collapse. Bears note that the financial sector faces substantial challenges. Many of the largest holdings in the ETF are state-owned banks. To stimulate the economy in recent years, the central government pressured banks to take on debt and assist borrowers that were not creditworthy. Now, the heavily indebted banks are faced with many loans that may never be repaid.

To obtain more diversification, consider pairing iShares FTSE China 25 with WisdomTree China Dividend ex-Financials CHXF . The WisdomTree fund is broadly diversified with 13% of assets in consumer staples, 24% in energy, and 15% in telecommunications. By putting half of your stake in each of the two funds, you would have 29% of the assets in financials, a reasonable allocation. The WisdomTree fund uses a careful weighting system to insure diversification. The portfolio always includes assets in nine sectors, and no one sector can account for more than 25% of assets. No one stock can account for more than 10% of assets. In each sector, stocks are weighted according to the total dividends that they pay. So companies with rich dividend streams dominate the fund. That could help to stabilize results because dividend payers tend to have reliable cash flows and solid balance sheets. Holdings include China Mobile CHL , a dominant cellular provider, and oil giant PetroChina PTR . WisdomTree research director Jeremy Schwartz argues that the outlook for the portfolio companies remains bright. "Growth in China could slow, but the prospects are still strong for many of the leading companies," he says.

Morningstar analyst Patricia Oey recommends SPDR S&P China GXC , which has 29% of assets in financials. Holding $952 million in assets, the SPDR ETF owns stocks listed in Hong Kong and New York. The New York listings include such fast-growing technology stocks as Internet search giant Baidu BIDU and NetEase NTES , which provides Internet portals and online games. In contrast, the iShares China fund focuses on stocks listed in Hong Kong and emphasizes big state-owned banks. Oey also likes iShares MSCI Hong Kong EWH , which has 26% of assets in financials. The ETF has $2.9 billion in assets. Instead of focusing on state-owned banks, the index concentrates on private banks that have more freedom to avoid bad loans. The financial holdings also include Hong Kong property developers that have been benefiting from growing demand for real estate. Follow @StanLuxenberg

This article was written by an independent contributor, separate from TheStreet's regular news coverage.